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2019 was a banner year for the precious metal mining stocks. The HUI — an index of gold producers — had a gain of just over 50% during that 12-month time-frame. Many gold and silver miners bested that performance by 2x or more, posting triple-digit returns.
Data by YCharts
After experiencing a brutal bear market from 2011 to 2015 — in which the HUI lost 84% of its value from peak to trough — then coming close to retesting those lows again in 2018, the index finally found its footing last year and confirmed that a new bull market had emerged.
For gold equities, they have officially exited what turned out to be the longest and deepest bear market in the history of the sector. The worst bear market in 77 years — going back to the 1930s. Typically, the most vicious bear markets are followed up by the strongest bull markets. That’s what I believe is in store for the HUI, as everything is “just right” for gold stocks.
(Source: McEwen Mining)
In this article, we will discuss all of the reasons why this is a goldilocks environment for the miners.
1. Margins Have Greatly Expanded As Costs Remain Well Contained
In 2011, gold was surging and hit $1,900 per ounce at its peak. It remained at elevated levels throughout 2012, trading in a range of roughly $1,550–$1,750.
One would think that the gold miners would be going gangbusters during this time, but they were sorely underperforming the precious metal. While the HUI experienced a massive rebound from the 2008 financial crisis lows (which negatively impacted all asset classes, gold included), the index struggled to make any more headway in 2011. This despite gold’s advancement from $1,350 to $1,900. By mid-2012, the HUI dropped sharply and went into negative territory from pre-2008 crisis levels, while the physical metal was still up 75%.
There were several issues the miners were battling during the peak of the previous bull run. The key one being out-of-control costs throughout the industry, and this was hitting every facet of the cost structure. Cash cost (i.e. cost to mine), sustaining Capex (i.e. capital spent on current operations) and growth Capex (i.e. capital spent on new projects).
Cash costs were increasing as there were surges in input costs across the board — everything from wage pressure and higher material costs to rising oil and diesel prices. Oil surged 150% as the economy rebounded, topping $100 a barrel. As oil climbed, so did fuel and diesel prices, putting a strain on the mining companies, given the level of fuel/diesel consumption by the industry.
It was also during this time that the mining sector was focusing heavily on growing production rather than profitability. Large-scale projects were in the works, as the miners tried to capitalize on the surging gold price. But this created a swell of demand for material, labor, and machines to build and mine these projects. Which, in turn, created a shortage and drove up prices for these goods and services. The miners saw cost overruns of a significant magnitude.
The end result was a sharp rise in AISC and AIC for the companies in the sector. What should’ve been an extraordinarily profitable environment for the mining industry turned into a thin to zero margin debacle. For some miners, their AIC eclipsed the price of gold. It should be noted that the graph below is from an older data series, as it’s up to 2015 in terms of the actual costs. But it does give an accurate visual representation of what was occurring at the time.
Today, the environment is much different.
Cash costs for the mining industry have remained relatively steady over the last several years. Some key cost components have declined. While the prices of oil and diesel have risen since the 2016 lows, they have dropped ~50% and almost 30%, respectively, since early 2012. It’s highly likely that oil and fuel prices will remain well contained for the foreseeable future. It has been my contention for years that the oil sector has peaked as new sources of energy (that are cleaner and becoming cheaper and cheaper as they scale) spell doom for the oil industry.
“Growth At Any Cost” is also no longer the mantra for the gold mining industry. While companies are still building projects, the focus is on stable production and generating healthy profits.
Demand for machinery/equipment in the sector is muted, and that can be seen in Caterpillar’s (CAT) much lower growth rate over the last several years compared to where it peaked in 2011.
The data series below shows that mining companies’ cash flow allocation to Capex remains at historically low levels. While some might call this a trough, and expect miners to start devoting more cash flow to sustaining and growth projects, We believe the industry will stay well below the historical average for the foreseeable future.
As a result of contained costs and spending in the mining sector, there has been a mega-expansion of margins as the price of gold is above $1,500, yet the industry average AISC remains below $1,000 per ounce. Margins haven’t been this wide since the late 1970s. The graph depicts further declines in AISC in the near-term as the miners continue their push to lower costs and increase profitability.
This can be seen in the 5-year production, cost, and spending profile of the two largest gold miners in the world: Newmont (NEM) and Barrick Gold (GOLD).
Newmont is forecasting declining AISC over the next 5 years. The company has a program in place that will continue to improve its costs, is investing in highly profitable projects, and note the statement of “Capital discipline maintained with ~$1.0B of sustaining capital per year” in the slide below.
It’s a similar story for Barrick, as AISC is expected to trend lower while the company remains prudent with its sustaining capital spending plans. This year and next year there will be an increase in growth Capex, but a sharp reduction will take place from 2022-2024.
(Source: Barrick Gold)
Despite physical gold’s re-rating, the companies in this sector are keeping their eye on the ball and not repeating past mistakes of trying to shift gears and rapidly increase spending during this cycle.
Having said all of that, it’s naïve to think that if the price of gold keeps surging higher (which we expect), inflationary pressures will remain capped. We have to assume that eventually, this will all lead to increases in wages and other costs for the industry. It’s also likely that purse strings will be loosened and AISC (along with growth capital) will rise again if gold tops $2,000 per ounce.
So we don’t necessarily agree with the rosy forward-looking AISC estimates for the mining sector (including the ones above from NEM and GOLD). Assuming that the price of gold continues to trend higher, I don’t know if AISC will go down from this point.
It’s prudent to have the base case scenario be one in which gold continues to move to the upside, but pressure builds on AISC as well. In this scenario, we believe that current margins would still be maintained. Gold miners are wildly profitable at the moment, so this base case would be an extremely bullish environment for these companies.
As for upside to the base case, if the miners do a better than expected job of controlling AISC and AIC as this bull market in gold advances, then we still foresee rising costs for the industry. In this scenario, though, there would be further margin expansion as the gold price would outpace any cost pressures.
Considering that the industry is applying new techniques and technologies that are lowering costs and improving production/recoveries, the chances of the upside scenario unfolding are quite good.
Everything from HPGRs (high pressure grinding rollers) to automated and electric powered mining equipment is permeating the industry. Companies are becoming more efficient and finding cheaper, cleaner, and safer ways to extract ore from the earth and process this material.
In summary, margins are exceptional and there are zero signs that cash costs for the industry are about to surge. It’s a perfect environment for the miners.
2. Significant Deleveraging Of Balance Sheets
Barrick has gone from having almost $12 billion of net debt in 2012, to $3.12 billion as of Q3 2019. When Q4 results are released, we wouldn’t be surprised if they shaved another $1 billion off this total last quarter. The company will reach a net debt of zero in the not-to-distant future. Possibly later this year if there are more asset sales and gold keeps increasing.
But it’s not just Barrick, as many companies in the sector have rapidly brought down net debt over the last few years.
B2Gold (BTG) has seen an equally impressive decline in its net debt since 2017.
This year alone, Alacer Gold has reduced net debt from $245 million to just $47 million.
(Source: Alacer Gold)
The trio of companies discussed above are just a few examples; there are many more.
As the focus remains on keeping spending and costs low, balance sheets are being aggressively unwound. At current margins, companies will see cash pile up at a rapid rate. This is just the start.
The timing is perfect, as net debt for many is approaching zero just as gold takes off. This should result in a drastic appreciation in valuations during this cycle.
3. Gold Supply Is Falling
We’ve been wildly bullish on gold for the last several years because of the exceptional fundamentals. Not only has there been a considerable increase in the U.S. money supply (to satisfy the growing deficit/debt) — which shows no signs of slowing down — but there is a peaking mine supply as well.
The World Gold Council just posted 2019 mine production figures a few days ago, which showed production dropped. While the decrease wasn’t substantial (just over 1%), it was the first year-over-year decline since 2008. Also, notice in the graph above that a nosedive in production wasn’t expected to take place until 2021-2022.
The question is whether this recent surge in gold can arrest this new trend? The short answer is not immediately, as it takes time for any new mine production to come online. It will probably be 2-3 years before the current pricing environment will have a positive impact on output.
Even then, companies will remain careful with their spend levels as it seems they are content to replace production via consolidation.
We believe investors need to focus on the supply/demand fundamentals, as the annual supply of gold declines while demand sharply increases. This favorable environment for the miners will be in place for at least the next several years.
4. Gold Stocks Remain Oversold On The Long-term Chart And Perfectly Positioned For A Sustained Move Higher
Despite the stellar gains last year, the HUI would need to almost triple in value to re-test its 2011 highs. The long-term chart below shows how the HUI remains vastly oversold rather than overbought. The index hasn’t even reverted to the mean yet. The technical picture is also exceptionally bullish as the 200-week is rising, the 50-week just had a bullish crossover, and this is the time when the strongest part of the advance would begin (which we have been discussing with our subscribers). Everything is just right for a sustained move higher.
There has only been one reported quarter (Q3 2019) that reflected the H2 2019 surge in the price of gold, wait until there is a series of them in a row. So far this quarter, gold has been well above its average price during Q3 and Q4 of last year.
If $1,500+ gold is the norm going forward, then the HUI should be above 300 this year without any more help from the physical metal. Q4 results will start coming out over the next few weeks and could act as a catalyst for this move.
One Of The Top Picks In The Sector
Barrick continues to be one of my favorite gold stocks in the sector. The combination of net debt reduction, AISC under $1,000 (which gives them margins of well over $500 per ounce), along with stable production will result in significant free cash flow generation and a rapidly growing net cash position over the next several years. The current valuation of GOLD doesn’t reflect this new reality.
Barrick was one of the most undervalued large cap gold producers last summer. Using future EV/EBITDA projections, GOLD was trading at a large discount to peers such as Newmont and Agnico Eagle (AEM).
At the time, I said that Barrick’s stock had 30% upside over the next 2 years and that assumed a flat gold price. Since then, Barrick has returned 33% and notably outperformed its largest rival NEM.
However, physical gold has increased almost 20% as well, which has increased EBITDA for Barrick by 25% on a forward-looking basis.
Our previous price target for GOLD was a minimum of ~$18.00. Our new minimum price target is $22.50, given the higher EBITDA. The reduction in net debt is also naturally reducing the company’s enterprise value (assuming no movement in the stock price). Both sides of the EV/EBITDA equation are being positively impacted.
As this goldilocks environment continues for the sector, it’s likely that the price target for Barrick will increase yet again.
(Sources YChart, KitCo, VanEck, Newmont, Barrick Gold, Alacer Gold, B2Gold, WGC, StockCharts, Goldman Sachs, SomaBull)
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